Where will those expected tech profits come from?

Commentary: Separating earnings optimism from realism

JohnShinal

With tech earnings season set to begin next week, it’s a good time for investors to ask themselves where the surge in second-half profits expected by Wall Street is going to come from.

The first half of 2013 wasn’t a particularly strong one for tech-sector earnings, but you wouldn’t know it from the 14% surge in the Nasdaq
COMP, -0.01%
since the start of the year.

Profit within the technology component of the S&P 500 fell 4.2% in the first quarter compared to a year earlier, and analysts are expecting second-quarter earnings at tech companies to drop 8.3% on an annual basis, according to figures compiled by Zacks Investment Research.

The overall sector numbers have been hurt by several factors, including a weakness in PC sales that have depressed profits at Hewlett-Packard
HPQ, -0.33%
and Dell
US:DELL
and the 18% drop in first-quarter profit reported by Apple
AAPL, -0.87%
which earned more profit than any other tech company last year.

Yet the tech-heavy Nasdaq has kept climbing along with the S&P 500 Index
SPX, -0.23%
which is also up 14% year-to-date, as profits for the index overall were rising even as they were falling in tech.

The bullishness has been underpinned in part by the optimism of Wall Street stock analysts, who are still predicting a strong finish to the year for tech earnings.

Anticipating a second-half profit recovery, analysts estimate a 2.9% profit rise in the third quarter and a 5.2% gain in the fourth, presumably on stronger sales of tablets and smartphones during the back-to-school and holiday shopping seasons, as well as a surge in software buying by corporate customers.

The problem with those estimates is that technology companies get a sizable portion of their revenue from foreign customers, and while the U.S. economy has been marching ahead with its steady — if tepid — recovery, overseas economic growth has been much weaker.

“That’s the disconnect in my judgment,” said Sheraz Mian, director of research for Zack’s. “The rebound that needs to take place [to justify current second-half estimates] requires macroeconomic improvement not just in the U.S. but overseas as well.”

Samsung

Can smartphone sales save tech earnings?

Tech investors have been here many times before, of course.

During most of the 15 years I’ve covered tech stocks, analysts have predicted that a second-half earnings rebound would make up for first-half weakness.

This year, analysts are expecting a second-half profit rise of 4.2%, after a first-half drop of 6.3%, according to figures compiled by Mian.

The problem with those numbers for investors is that analysts are almost invariably too bullish when they first come out with their estimates.

Back in April, for example, analysts predicted that second-quarter earnings at tech companies would be just 3.1% lower than a year earlier.

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